Reform matters (Archived)
The Trump administration wants to radically alter the US regulatory landscape. Here, The Boston Company’s John Bailer argues that more pro-growth, pro-business policies would be positive for stock returns in 2018, but thinks even without them the outlook is bullish for US equities.
For a Trump administration fired up by the prospect of US tax reform and financial deregulation, 2018 is going to be a crucial year. With midterm elections looming in November, there will be a sense of urgency to deliver on its pro-business, expansionary policies and to reverse unnecessarily tough regulations introduced in response to the global financial crisis.
Much appears to be riding on the administration’s success. Since the tax reforms were unveiled, the prospect that corporate tax cuts and deregulation would strengthen the US economy and drive higher profits seems to have provided a tailwind for stocks.
The perceived importance to markets of fiscal stimulus has even become a political bargaining chip. In late 2017 Steven Mnuchin, US Treasury Secretary, warned that US stock markets would shed a “significant amount” of their recent gains if lawmakers do not pass tax reform.1
While this point of view might be effective at getting Congress motivated, it’s not one we agree with. We believe a wider reduction in regulations would generate upside for stocks. However, in our opinion, the so-called ‘Trump reflation trade’ does not depend on these reforms getting onto the statute book. We remain bullish on US equities, irrespective of whether the reforms are finalised, remaining unscathed.
Meanwhile, the prospects of regulatory reform has given stocks a boost. Following the Presidential election result, the market immediately bid up high tax-rate companies that had the most to benefit from lower taxes. This included telecoms, cable and auto companies. That tax reform premium subsequently disappeared entirely, with those companies’ share prices returning more or less to where they were before Trump was elected.
That, in itself, created an opportunity. To us, valuations of high tax-rate companies, particularly financials, do not fully discount tax cuts. We believe a full programme of reform could give these stocks a 10-20% earnings uplift. If it doesn’t happen it is no great loss given current pricing.
Changing of the guard
Turning to financial deregulation, the likelihood of a wholesale repeal of the Dodd-Frank Act, which was introduced in 2010 in response to the global financial crisis, is very low.
However, the Trump administration doesn’t need to overturn the Act in its entirety to create a more business-friendly climate that is earnings accretive. All it needs is a tweak to existing rules for there to be benefits to business.
This was reflected in a Treasury Department Report, which rather than advocating wholesale repeal of the many Dodd-Frank Act post-crisis requirements (including the so-called Volcker Rule2) recommended rebalancing and tailoring existing regulations.3 This more flexible approach to reform still has the scope to radically change the rules given the Dodd-Frank legislation left regulators with a lot of discretion.
However, by making key appointments, Trump can potentially encourage a more pro-growth, pro-business mind-set and possibly a reinterpretation of the Act as it stands, without any amendments. This process may already have been set in motion by October’s appointment of Randal Quarles as the Federal Reserve’s vice chairman for supervision.
The role gives Quarles oversight of the stress testing of large US banks. Banks with more than US$50bn in assets have monthly, quarterly, and annual data submissions, in addition to undergoing stress test exercises twice a year, all of which requires these banks to expend significant amounts of time and resources. Some lightening of regulation seems likely given that before he was appointed, Quarles had called for changes to these bank stress tests as well as the Volcker rule ban on proprietary trading.4
Trump’s choice of the new head of the Federal Deposit Insurance Corp (FDIC), not to mention that of Jerome Powell as the next Federal Reserve chair, could also help to push forward regulatory reform as 2018 progresses.
Positive for financials
Any moves on regulation are likely to have a particular impact on banking, a sector where we believe the fundamentals look positive.
Banks are well-capitalised and the conservative mind-set since the global financial crisis means their loan books are better than they have been for many years. In 2017 the financial institutions asked to take the Comprehensive Capital Analysis and Review (CCAR5) all passed the adverse scenario test. It was the first time this has happened since the tests were established in the wake of the financial crisis.6
With their balance sheets in such good shape, banks have been able to return more of their capital to shareholders. In 2015 the top five US banks in terms of market capitalisation7 returned around 60% of their income to shareholders as dividends or stock buybacks. By 2016 that figure had grown to 76% and in the past year it reached 98%.8
In our opinion, banks are already some of the most attractive dividends payers in the US and lighter regulations would allow them to return even more capital to shareholders as dividends or stock buybacks.
Cheapest in decades
Secular stagnation and low interest rates have pushed low-volatility and growth stocks to extreme valuations. However, we are very bullish about value stocks, particularly financials.
Even without Trump-led reform, we believe the outlook for financials in 2018 looks extremely favourable. As the Fed moves to normalise monetary policy, rising interest rates and the unwinding of QE will be positive for net interest margins and profits.
We do expect to see some loosening of regulation, which could give earnings a further boost. Fully fledged tax reform would be the icing on the cake.
What to watch in 2018
- US equities performance not dependent on tax reforms
- Lighter regulation will particularly impact banking
- Financials look well-capitalised and cheaper than they have for decades
1. Financial Times ‘Mnuchin warns of fall in equities without Trump’s tax reforms’, 18 October 2017.
2. Dodd-Frank includes the Volcker Rule, which prohibits banking entities from engaging in proprietary trading and limits investment in certain hedge funds and private equity funds.
3. US Treasury: ‘A Financial System That Creates Economic Opportunities Banks and Credit Unions’, June 2017.
4. Financial Times: ‘Senate confirms Randal Quarles as Fed regulatory chief’, 5 October 2017.
5. The 34 largest US banks holding more than 75% of the total assets of all US financial companies. Source: Federal Reserve: ‘Comprehensive Capital Analysis and Review 2017: Assessment Framework and Results’, June 2017.
6. CNBC: ‘For first time since financial crisis, Fed clears all big banks' capital return plans’, 28 June 2017.
7. JP Morgan Chase, Bank of America, Wells Fargo, Citigroup, US Bank Corporation.
8. FactSet, Company reports, Bernstein analysis and estimates, 29 June 2017.